Linde “Deja Vu”

Praxair’s history can be traced all the way back to 1907 when the company was formed within German-based Linde Air Products Company. During World War I, Linde was required to divest their industrial gas business to Union Carbide, which later spun off the gas business as a stand-alone entity, “Praxair,” in 1989. Praxair’s story came full circle in August when Praxair entered merger talks with Linde. The companies signed a nonbinding merger contract in December.

The industrial gas industry has a long history of consolidation. With Air Liquide’s acquisition of Airgas in 2015, the industry is now a four player oligopoly, with Air Liquide, Praxair, Linde and Air Products representing 75% of the global market. Praxair’s merger with Linde checks all the boxes strategically and presents value creation opportunities for the combined company long term.

First, the companies’ geographic footprints are highly complementary. Praxair’s leading positions in North America and Latin America align well with Linde’s strong footprint in Europe and Asia Pacific. There is asset overlap across countries, which is likely to lead to required divestitures in the U.S., Brazil, Chile, Germany, Poland and Scandinavia. However, the divestitures should prove manageable. Our most likely scenario is for $3.3 billion of divested revenue, which would still result in strong return on invested capital (ROIC) from the merger.

Second, management estimates they can deliver cost synergies of $1 billion from the combination. Praxair’s management team will be able to leverage their industry-leading operating system into Linde’s undermanaged global footprint, creating material margin expansion at legacy Linde. Outside of lower production costs, SG&A (Selling, General and Administrative) expenses and corporate overhead, the combined entity will benefit from logistical/distribution synergies in regional markets. The opportunity is substantial, as these cost buckets represent one third of total expenditures. We believe management’s cost synergy target is reasonable with potential upside long term.

Finally, we think that the merger offers pricing and capital deployment benefits. Overall industry pricing will benefit from the market consolidation, but legacy Linde pricing will also benefit from Praxair’s management team and market discipline. Combined ROIC should also benefit from a management team with a stronger record of capital deployment into new project capital expenditures (CAPX) and expansionary CAPX.

Deflated Expectations

Praxair has faced a myriad of revenue headwinds over the past several years, including weak global manufacturing & industrial demand, deflation and currency headwinds due to the strong U.S. dollar. As we enter 2017, it looks likely that the first two headwinds will subside. Global Purchasing Managers’ Indexes (PMI)’s, which are leading indicators for manufacturing demand, improved meaningfully exiting the year, particularly in the U.S., Europe and Asia Pacific. Moreover, we are seeing the first indicators of global inflation growth since mid-2011.

Praxair’s business benefits from a moderate rate of inflation in the broader economy. The industrial gas business has considerable pricing power given the regional oligopolistic nature of markets and high switching costs. The distance that gases can be distributed is limited given the high transportation costs and pipeline limitations for on-site demand. When entering a market, Praxair puts in place long-term take-or-pay contracts (10-20 years) with built in price escalators tied to inflation. Praxair builds capacity greater than contracted demand and sells remaining merchant volumes (delivered by truck) and packaged gas volumes (delivered in cylinders) to other local customers at high incremental margins. Historically, Praxair has been able to garner price increases above inflation for these off-take volumes.

Long term, we continue to expect the industrial gas industry to outpace global industrial production. The outperformance will come from two factors: growing application and outsourcing of captive production. We continue to see growth in new applications in life sciences, food & beverage, electronics due to higher environmental regulations (refining, waste water treatment). Moreover, as production processes have advanced across industries (welding is one example), the amount of industrial gases used per application has increased over time. Application growth should add 1-2% to revenue growth over our investment horizon. In addition to growing applications, customer outsourcing of industrial gas production to third parties, such as Praxair, Linde and Air Products, will benefit industry growth, albeit at a slower pace than in the past. There is still room for growth in developed markets (North America, Western Europe, Japan), where 85% of industrial gas production is outsourced, but the real opportunity lies within Emerging Markets, where over 50% of production is still captive. Praxair will benefit from outsourcing across Latin America, Asia Pacific and India.

Capital Allocation

Praxair garners high return on invested capital due to the attractive industry characteristics mentioned previously and also from strong operational excellence and capital allocation. Management has historically been methodically disciplined in the projects they bid, requiring double-digit ROIC, attractive local industry structures and partners that are well capitalized and have low cost positioning in their respective industries. This discipline has de-risked Praxair’s asset base—of particular note is the absence of troubled heavy industrial assets in China.

While the global pipeline for new industrial gas units remains subdued, there are several areas of opportunity for Praxair. Low energy prices in the Gulf Coast have led to strong demand for refining and petrochemical projects (low feedstock prices). Praxair is uniquely positioned to win this backlog given their leading position and extensive pipeline infrastructure in the Gulf Coast. They have already won three large projects, which are slated to come online in 2017-19, and they are well positioned for additional contract wins in 2017-18.

Praxair’s revenue will benefit from new project contributions of approximately 3% annually over the next several years. This along with productivity gains and lower CAPX requirements should lead to an increase in free cash flow over our investment horizon. Management has a strong track record of adding value through mergers & acquisitions as well as through share repurchase. We expect this to continue in 2017 and beyond.

Valuation

We believe Praxair is a high-quality business with a durable competitive moat. Growth in industrial gas applications, annual price increases and productivity improvements should drive high single-digit earnings per share (EPS) growth over our investment horizon. This coupled with a 2.5% dividend yield could lead to double-digit shareholder returns before accounting for any benefits from a Linde merger. With the stock priced at $115 against our estimated stand-alone valuation of $140 and pro forma Linde estimated valuation of $150, we think Praxair offers an attractive return profile with downside protection.

As of December 31, 2016: Praxair, Inc. represented 2.6%, 4.3% and 1.7% of Value, Research and Balanced Funds’ net assets, respectively. Portfolio composition is subject to change at any time. Current and future portfolio holdings are subject to risk.

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